I am writing this piece the morning of December 3, the first day of a special session of the Illinois General Assembly. I have little faith that anything I say will shake the legislative leaders from their plan – a delicate political compromised worked out behind closed doors in recent weeks. But I am taking the time to write anyway because even a small chance of influencing the debate seems worthwhile, given how much is at stake.

I co-wrote an op-ed in the Champaign News-Gazette nine days ago expressing my deep concern about how the proposed reform would affect higher education in Illinois – especially our ability to retain our best people. Most of my worst fears in that op-ed were realized when the text of S.B. 1 was released yesterday. In the interim, I was quoted in several news articles as reporters were looking for insight as bits and pieces of information leaked out of Springfield. In one article, I was quoted as saying that if I had to choose between this reform, and doing nothing, I would do this reform. That surprised many of my colleagues, so another motivation for this piece is to clarify this statement.

The easy answer is to say that if I had to choose between dying and having both of my legs amputated, I would choose the latter. But this should not be interpreted as suggesting that I think leg amputation is necessarily a good idea, particularly when equally effective but far less damaging treatments are available.

Similarly, we need pension reform in Illinois. Doing nothing is simply not an option, at least in the medium and long run. So I do believe that bad reform may, on net, be better than no reform. But that assumes bad reform is our only option.

S.B. 1 is bad pension reform because it will lead to an exodus of top intellectual talent from our universities. (More details below.)

Is it our only option? From any reasonable perspective – for example, actuarial, economic, financial, etc. – the answer is clearly “no.” There are many ways to closing the fiscal gap, and S.B. 1 is only one, and particularly flawed at that.

But from a political perspective, the answer is harder. I worry greatly that this may be our only option, given how dysfunctional our state political system is. If it really is S.B. 1 or nothing, then I might hold my nose and support it, knowing that universities will have to go to extraordinary lengths to undo some of the extensive damage this will cause. That would come at a steep price – during the transition, we will lose some of our very best people. It could literally destroy the pre-eminence that has taken decades for the University of Illinois to achieve.

I am not a political scientist. But I do understand incentives, and I have followed the politics of Illinois pension reform closely for many years. And I was struck by a particularly insightful question that one of my politically-experienced and insightful friends asked me: “What leads you to expect that if you could and did kill this bill, that those same politicians would be likely to produce a better outcome the next time?” (I have edited the question a bit). My answer is that we should be able to do better. But I am not sure we really can.

Even so, this reform is so poorly designed that, as a pension expert and employee of the University of Illinois, I feel compelled to oppose it.

Because the General Assembly may vote as early as today, I don’t have time to go into a lot of detail or polish my writing. Nor do I have time to fact check every single detail in this post. I am writing with a sense of urgency. I will post corrections later if I find any substantive mistakes. But here are a number of thoughts on the bill, in the form of a simple Q&A.

First, why does this problem exist?

The answer is easy: for many decades, Illinois did not pay its bills. Our pensions have been underfunded every single year for decades. We hid behind flawed government accounting, pension funding “holidays,” and found temporary cover in the rising equity markets during the technology bubble.

- This is the fault of our politicians. The problem is bipartisan – Republican and Democrat Governors have underfunded our pensions, and both Democrats and Republicans in the House and Senate have voted to do so.

- Public workers are not to blame. They paid their share and were promised constitutionally protected pensions in return for lower salaries.

Why do we need reform?

- Regardless of whose fault it is, the pension costs are fiscally unsustainable. We have dug a hole so deep that we have no choice but to partially default on some of our promises. It is a sad truth. But it is the truth.

- We have a pension funding hole that is officially about $100 billion. But these official statistics drastically understate the problem. It is only a $100 billion hole if you think we can generate 7.5% to 8% returns on the pension assets every single year without any risk. No economist believes that. When valued the way any financial economist would value the liabilities, the funding shortfall is more on the order of $250 billion.

- Illinois has the lowest bond rating of any state in the country. This drives up our borrowing costs, and sends a clear signal to companies and entrepreneurs that taxes will be higher in the future. Few things drive away business more quickly than an unstable fiscal environment.

- We have enormous structural deficits that show no signs of abating. Even with the “temporary” tax increase (when the individual rate rose from 3% to 5% of income and the corporate rate increased proportionately), we still are running deficits. We cannot just keep raising taxes, or we will start an economic death spiral in the state as mobile capital and labor flee the state.

Is it possible to do this in a sensible way?

- Yes, but it will not be free from pain. Put simply, there is only one way to solve this – somebody must pay. The question is how to share that burden equitably. Taxpayers benefitted for the last several decades by receiving public services at a substantial discount because we borrowed against the pensions to pay for those services. Retirees benefitted from pensions that were larger than we were paying for. Unions benefitted from bargaining for greater benefits when it was hard to get salary increases. Universities and school districts benefitted by not having to directly pay the full cost of their hiring. Everyone – knowingly or unknowingly – was complicit. Everyone benefitted. So everyone should have to share the pain of the solution.

- No matter how much the Wall Street Journal may wish it to be so, there really is no conceivable way to eliminate the existing unfunded liability right away. One would have to violate the state constitution by defaulting on 60 percent or more of all benefits that have already been earned by current retirees and current workers.

- With several other experts, I co-authored a pension reform proposal that outlined Six Simple Steps to reform pensions in a rational way. It spread the pain, aligned incentives, and solved the state’s problem in the long-run. Details can be found at the IGPA website.

How would S.B. 1 affect bondholders?

- Bondholders are clear winners. Any substantial reduction in pension benefits is great news for bondholders. After all, they simply care about their debt being repaid, and pensions are competing for scarce dollars.

How would S.B. 1 affect participants in the Self-Managed Plan?

- Participants in the Self-Managed Plan are totally unaffected.

How would S.B. 1 affect low income state employees in the Traditional or Portable Plan?

- If someone close to retirement has earned a pension of $30,000 per year or less, and worked for the state for 30 years, the changes will be small. Younger workers still many years from retirement will have to work more years before being eligible, and you would not receive the cost of living adjustment in up to 5 of the first 10 years you are retired.

- All workers would benefit from the 1% reduction in employee contributions. So given how small the benefit cuts are for low income workers, they may actually come out ahead.

How would medium earning state employees in the Traditional or Portable Plan be affected?

- By medium earners, I am referring to those with annual salaries from about $45,000 to about $110,000. In addition to the increase in retirement age, these workers will see a cap on their cost of living adjustment in retirement. Instead of getting a 3% per year increase on their total pension, they will receive an inflation adjustment only on the first $1000*X dollars, where X is the number of years they worked. So, for a 30 year worker making above $45,000 per year (which roughly corresponds to a $30,000 pension), you will see smaller future cost-of-living increases. If you are earning $90,000 per year, and earning a pension of around $60,000 after 30 years of service, you will essentially be getting a cost-of-living increase on only half your pension.

How would high earners in the Traditional or Portable plan be affected?

- This is where the substantial pain comes in. The key provision – the one that takes a meat-axe to pensions – is the cap on pensionable salary. If you earn above approximately $110,000, all future salary increases will be disregarded for purposes of calculating your pension.

- To see how much this matters: Suppose you have worked here for 5 years already, and expect a 3% per year salary increase (this is 3% nominal, so if inflation runs 3%, this means you are getting no increase in real terms). Given the miracle of compounding, this means that your salary will more than double in nominal terms over 25 years. So if you were to retire after 30 years, you will be getting 66% of your current salary rather than your doubled salary. This is a 50% cut in pension benefits.

- This 50% cut is ON TOP OF the reductions from the increase in retirement age and the COLA reduction. All in all, I have estimated that the total cut could be as much as 65% for some workers.

- The cut is steeper the more years you have left ahead of you, and the steeper your salary trajectory.

- Even if you are not subject to the cap now, if your salary grows faster than the cap, you could become subject to the cap later.

- In present value, this is equivalent to a substantial cut in future total compensation – on the order of 10-15% of salary now and forever.

Is this constitutional?

- It depends on how the Courts interpret the non-impairment clause. Under the strictest interpretation, any cut would be a violation.

- But I continue to think the most reasonable interpretation of the clause is that the state cannot cut benefits already accrued as of the date of reform. Under this interpretation, the retirement age increase would be a violation, but the other provisions would not be because they apply only to future benefit accruals.

- It appears that lawmakers want to argue that a 1% reduction in contribution rates will be sufficient “consideration” to offset the benefit cuts, thus making this legal. That seems absurd to me – a 12% reduction in contributions does not compensate for a 60% cut in benefits. But I am not a lawyer, so who knows?

What will the long-run impact on U of I be?

- The university is going to face a tough problem – how to prevent an exodus of top talent without “breaking the bank” already-strained institution.

- Don’t be surprised if this translates into a long-run reduction in hiring plans as a way to come up with the funds to pay for any attempt to retain existing people.

How will the University of Illinois respond?

- First, the University is officially opposing the legislation, as it should.

- Second, University leadership seems well aware that they are going to have to do something to partially offset these changes or we are going to lose our very best people – especially in higher earning units like Medicine, Engineering, Business and Law. I would anticipate some effort to provide employer contributions to a 403(b), or something similar, to partially offset these changes for those most affected.

What should I do now?

- Call your lawmakers and ask them to vote no.

- Then, if it passes, do NOT take any irreversible actions. Give the Courts time to sort out the constitutionality. And give the University time to come up with a partial remediation plan.

- Perhaps talk with a financial planner or advisor about steps you can do to increase retirement savings on your own.

Earlier this year, I co-authored a proposal with four colleagues to reform the Illinois State Universities Retirement System. My motivation for doing so was quite simple: the fiscal crisis facing the state of Illinois is very real, “doing nothing” is not an option, the politicians seemed to be making little headway on a solution, and the ideas that were under consideration appeared to be driven far more by ideology than by concern about good retirement policy and good fiscal policy. Given that I have spent the past 15 years of my life developing academic, policy and practical expertise on issues related to retirement income security, I thought I owed it to Illinois taxpayers to make a serious attempt to bring some balanced, centrist thinking into the discussion. My four co-authors brought exceptional expertise in areas of university administration, benefits design, state and local public finance, and other highly relevant topics. Together, we proposed six specific reforms to the SURS system.

Our “Six Simple Steps” proposal was subsequently endorsed by the Presidents and Chancellors of all of the public universities in Illinois. It has also received favorable feedback from many participants and retirees. Over the summer, our proposal gained serious political traction when the bicameral, bipartisan pension committee of the Illinois General Assembly began to treat it as a leading possibility for breaking through the political logjam that had stifled prior attempts at reform.

Now that our proposal – which is sometimes referred to by others as the “Universities Plan” or the “IGPA Plan” – has gained traction, the political knives are coming out on both sides of the ideological divide. This is not surprising: under our proposal, faculty are being asked to contribute more, retirees are being asked to receive less, the universities are being asked to take on greater financial responsibility for future costs, and the state is being put on the hook for paying down the enormous unfunded liability. There is plenty of pain to go around.

We did not cause the pain, of course. The pain was caused by many generations Illinois General Assembly members who failed to behave with even a modicum of fiscal responsibility. We are just asking legislators, participants, retirees and taxpayers to be honest about the severity of the problem and to take meaningful steps to stop the fiscal bleeding. But, in a highly politicized environment, with billions of dollars at stake, I am not at all surprised that ideologues and interest groups are pulling out their knives and trying to cut down our proposal.

So allow me to let you in on a little secret – I don’t love our proposal either. A few aspects of it leave a bad taste in my mouth, in the same way that some life-saving medicines do. However, I honestly consider to be the best – by far – of a wide range of distasteful options.

Let’s be honest: If I lived in a state where the state government was not dysfunctional, where we did not have strictly binding constitutional constraints, and where we could draw up our pension system from a relatively clean slate, I would NOT design a system exactly like the one we are proposing. Rather, I would commit the state to a credible funding path; I would raise the normal retirement age to be in line with Social Security; I would fully index benefits to inflation and, if needed, pay for it through downward adjustments to initial benefits; and I would align incentives by making the entities responsible for hiring decisions (e.g., the universities) also be responsible for paying the full benefit costs associated with those hiring decisions. While I am dreaming, I would also require the state to use accounting rules that transparently communicated the real economic cost of pensions, rather than hiding the true costs behind intellectually flawed government accounting standards. Then again, if I lived in such an ideal world, we probably would not be facing the worst pension funding crisis of any state in the nation, and our proposal would have been unnecessary in the first place.

But we, the residents of Illinois, do not live in such a world. Rather, we live in a state where for many decades our political leaders have failed to make good on the state’s most basic financial obligations. As a result, the time has come for us to take our fiscal medicine: everyone must make sacrifices. Unfortunately, the very constitutional protections that were intended to protect retirees now prevent us from enacting the most sensible reforms (such as raising the retirement age, which nearly every serious analyst agrees is a good idea): instead, we are forced to use second-best policy tools (such as reducing COLAs) simply because they have a better chance of passing constitutional challenge. And we live in a state where after several unproductive years of debate, various powerful politicians have made it crystal clear that certain types of reform are political “must haves” and others are “cannot haves,” a situation that further narrows the realm of politically feasible options.

With these and other painful realities in mind, my colleagues and I set out to design a plan that made the best of a truly terrible situation. We settled on a plan that:

Has a reasonable chance (although not guaranteed) of being deemed constitutional;

Has a reasonable chance of being politically feasible (as demonstrated by the recent support the plan has received from the bicameral bipartisan pension commission);

Will substantially improve the state’s long-term fiscal situation;

Preserves a smaller defined benefit (DB) element to recognize that many public workers in Illinois are not in Social Security, but also creates a defined contribution (DC) account, in an attempt to balance the various strengths and weaknesses of the two types of plans and create a better system than the Tier II system in place for new employees;

Improves the retirement security of new employees through more favorable vesting rules (that are also more closely aligned with private sector practice);

Provides real – if imperfect – inflation protection by linking increases to the CPI, rather than providing an arbitrary annual nominal increase that leads to enormous fluctuations in retirees’ real standards of living;

Substantially increases the likelihood that the state will begin to pay down the unfunded liability, both by reducing the state’s share of future costs and by providing the stakeholders with a legal right to enforce state funding;

Appropriately aligns incentives so that universities bear the full cost of their hiring decisions;

Suggests many other features that attempt to bring some rationality and transparency to a complex and opaque system (such as reducing the hidden subsidy provided via a financially inappropriately high Effective Rate of Interest);

In recent weeks, once it became clear our plan was gaining political traction, two different analyses came out criticizing our Six Step Plan. There are two things to note about these criticisms:

Second, the criticisms are striking in the extent to which they are mirror-images, taking precisely opposing views to one another. The first of these critiques was offered by the Illinois Policy Institute. They criticize our plan for preserving the DB system, not moving fully to a DC world, not eliminating COLAs, not saving enough money, and taking too long to phase in the changes. The second of these critiques is by a researcher at University of Illinois at Chicago and the head of Keystone Research Center. They criticize our plan for not preserving the DB system in its entirety, for suggesting the introduction of a DC element, for partially reducing COLAs, for asking the state to pay down the unfunded liability too quickly and for cutting benefits too much. And, in an amazing feat of mental gymnastics, they also suggest that by reducing spending the plan will somehow raise costs to the state.

To the extent we were trying to design a proposal in the “sensible center” of this debate, I will take these completely offsetting criticisms as confirmation that we are on the right track.

Here is a brief table summarizing how the two critiques often negate each other, in their own words (followed by my parenthetic and italicized remarks summarizing their view in my own words).

Our Proposal

Illinois Policy Institute

KeyStone Research

COLA: Switch from 3% automatic annual increase to 50% of CPI

“The IGPA plan fails to achieve the savings necessary to reform Illinois’ pension system by only partially reducing cost-of-living adjustments, or COLAs”

(in other words, we should completely eliminate the COLA)

“It would undermine the retirement security of Illinois public‐sector retirees, and especially harm those who live a long retirement”

(in other words, we should make no changes to the COLA)

Hybrid DB/DC system for new employees

“The IGPA plan takes reform in the wrong direction by maintaining the defined benefit pension system for current workers”

(in other words, we should totally eliminate the DB and have only a DC)

The plan would “be as bad as or worse than Tier 2 because of the

reduction in the defined benefit portion of the plan from a 2.2% multiplier to 1.5%.” and “DC plans are less cost effective”

(In other words, we should totally preserve the existing DB and not have any DC)

Force the state to pay down the unfunded liability

“this plan allows the pension systems and their members to take legal action to compel the state to make the pension payment. Pension guarantees similar to this plan prioritize pension payments above all other government services, jeopardizing funding for those who rely on it the most.”

(in other words, we should not provide additional tools to force states to pay down the unfunded liability)

“This could be coupled with extending the time

taken to get to 100% funding.”

(In other words, we should not actually reduce benefits, but simply stretch the payments over a longer period of time)

Reduces state’s overall cost as much or more than other proposals

“Savings this small not only fail to solve the problem, but will also require lawmakers to revisit Illinois’ pension crisis again in just a few short years.”

(In other words, we simply did not slam workers and retirees enough)

“the Universities proposal could result in higher costs to taxpayers”

(In other words, even though they think we are cutting benefits too much, they falsely claim that somehow this risks increasing costs)

I can understand why those who advocate for the smallest possible government would be disappointed with a plan that does not squeeze out even more savings from the pockets of public sector workers. I can also understand why some public sector workers and retirees would oppose any benefit reduction. But such extreme views, while potentially useful for advocacy purposes, do not make for good public policy. The above comparison make it self-evident that these two critiques are attempts to bolster opposing untenable positions: the Illinois Policy Institute would prefer that we decimate retirement security, and the KeyStone group naively acts as if we can solve this crisis without meaningful changes to benefits. Supporters of both positions will be disappointed with any realistic proposal that actually solves Illinois’ pension problem while preserving retirement security of public workers.

You may not like our plan. As I noted earlier, I am not in love with it either. But I still think it is the best idea out there so far. Very little in the Illinois Policy Institute or Keystone critiques alters my view with the exception of continuing the existing Self-Managed Plan as a voluntary option for some new employees, as suggested by the Illinois Policy Institute, although I do not think it is the best choice for the median employee.

I am totally open to the possibility that better ideas than ours may still be out there – and if either of these two groups (or any other group or individual) have substantive suggestions that are fiscally responsible AND politically feasible AND constitutional AND not unduly harmful to public employees, I would love to hear them. So far, however, I continue to believe our Six Step proposal is the most serious proposal on the table.

Prof. Jeffrey R. Brown, 8/19/2013

(Author’s note: the opinions expressed here are those of the author – Prof. Jeffrey Brown – alone, and do not necessarily represent the views of any of my co-authors or the University of Illinois.)

Earlier this week, I released a report co-authored with Avijit Ghosh and Scott Weisbenner (both of the University of Illinois) and Steve Cunningham (Northern Illinois) that – yet again – tries to make the case for pension reform. The news release can be found here and the full paper (including a one page summary) can be found here.

In a nutshell, the plan has three components:

1. Change some of the SURS rules to reduce costs and increase transparency. This includes pegging the SURS’ effective rate of interest to long-term bond rates. For my prior musings on this topic, click here to see the blog I wrote on this back in June of 2010, entitled “A Hidden Pension Subsidy in SURS.”

2. Providing participants with an opportunity to opt out of their automatic annual adjustment (sometimes called the COLA) in exchange for a lump-sum that is calculated to give participants a bit of a “haircut.” We consider this to be a reasonably fair exchange, especially given its voluntary nature, in sharp contrast to the forced choice that has been proposed in other legislation (for example, see Nolan Miller’s post entitled “The Choice Between Two Unconstitutional Options is Not Constitutional.”)

3. Expand the Illinois state income tax base to include retirement income. There is really no compelling economic reason to exempt retirement income from the Illinois state income tax, and this may be the only way to get the retired generation to be able to contribute to solving our fiscal problems.

Whether or not our proposal has an influence on the debates in Springfield is anybody’s guess. But one thing is clear: absent some time of substantial reform, Illinois is teetering close to a true fiscal cliff, one that will make the Washington DC fiscal cliff look like a small step down.

After a week of legislative wrangling that had more twists and turns than Hawaii’s famous “Road to Hana,” the Illinois General Assembly failed to come to agreement last week on a pension reform package in time for yesterday’s May 31 deadline. As a result, they will return to Springfield – possibly this week – for a special session facing an even larger hurdle for passing reform legislation: by Illinois law, bills passed after May 31 require a three-fifths vote rather than a simple majority.

Agreement fell apart over the issue of who should pay for the “normal cost” of future public pension accruals. “Downstate” lawmakers objected to shifting all of the costs onto school districts, public universities and community colleges on the grounds that this would lead to higher property taxes to fund teacher pensions and do grave damage to the ability of our university system to compete for academic talent. Once Democratic Governor Quinn agreed to pull this cost-shifting out of the bill, Democratic House Speaker Mike Madigan withdrew his support of the bill.

As I wrote this past Wednesday, one of the grave concerns I have about the leading proposals is that so many of our elected officials seem perfectly content to shift all of the costs onto universities and school districts while maintaining legislative control over the design of the benefits package. This is a mistake on so many levels. The separation of responsibility and control is a recipe for fiscal shenanigans. It is also highly disrespectful of the employer-employee relationship that Bob Rich and I wrote about in our pension reform proposal earlier this year.

Although I still like the plan that Bob Rich and I put out, it seems clear that the General Assembly has gone another route. But given that they are stuck on the cost-shifting issue, I thought it might be useful to put forth a more radical proposal that would respect the constitutional constraints, appropriately align the incentives of all the affected parties, respect the employer/employee relationship, and still save the state billions. Perhaps most importantly from a political perspective, it might overcome the cost-shifting stalemate, because it shifts the costs but offers something very valuable in return. This proposal would apply to those institutions – such as school districts, universities and community colleges – that, while public, are not part of the state government apparatus itself.

While “radical,” the idea is deceptively simple. Here it is in 4 simple steps:

1.The state agrees to pay 100% of all pension benefits that have been accrued by public sector retirees and current workers as of 7/1/2013. Whether the state wishes to do this by paying down the amortized unfunded liability, or simply provide the cash as need to pay benefits, is immaterial, so long as they respect the constitutional guarantee and pay it. Not only does this respect the constitution, but it would also be fair to the generations of workers and retirees who consistently paid their share to the pension fund while the politicians enjoyed their “pension funding holidays.”

2.The existing public pension plans – for example, TRS and SURS – are closed to all further accruals as of 7/1/2013. No new benefits will be earned under any of the plans.

3.Going forward, each state employer is given 100% autonomy – free from the shackles of state regulation and political interference – to construct a benefits package that is optimally designed for its own employees. In order to comply with federal law that applies when a state like Illinois opts out of Social Security, each employer would be required to provide a retirement package that is at least as generous as Social Security. Beyond that, it would be up to each employer to determine the optimal mix of wages, pensions, and other employee benefits that would be required to attract, retain, motivate, and manage the retirement of their workers. If similar employers wished to joint together as a group (e.g., all community colleges) to provide a common pension plan, or if unions wanted to provide multi-employer pensions funded by a group of employers, they would be permitted to do this. But if the University of Illinois decided that its needs differed sufficiently from other public universities, they would have the freedom to go their own way.

4.The state would agree to a pre-determined, annual “block grant” (basically, an extra appropriation) to each employer that would start out as an amount equal to the “normal cost” of providing pensions, and would gradually decline to zero over a 20-year period of time. This would slowly shift the entire financial burden of providing pensions from the state to the employers themselves.

In essence, this plan calls for 100% cost-shifting, but with two critical differences relative to the reform package being debated last week. First, and most importantly, it accompanies the cost-shifting with a freedom from political interference. Second, it spreads the cost-shifting out over a much longer period of time (twenty years instead of approximately eight or so) in order to ensure that employers can adapt.

If there is anything I have learned from observing our Illinois state government in action, it is that it cannot relied upon to design a sensible pension package that is fiscally sustainable, credible to employees, and meets the diverse needs of our public employers. So if they are so eager to get out paying for pensions, let’s take this idea all the way – aside from atoning for their past sins by making good on constitutionally guaranteed promises that they have so far failed to fund – let’s have the state get out of the pension business altogether.

Doing so would free employers and employees from being subject to the unpredictable whims of the states’ politicians. And that freedom, it seems to me, is priceless.

The Illinois General Assembly stands on the verge of passing an historic public pension reform. After many decades of serial underfunding, the legislature and Governor have finally agreed to act. The news for taxpayers is primarily good: through a combination of cost reductions and cost shifting, the public pension fiscal drain on state revenue is being substantially reduced. This is welcome news in a state with a fiscal situation as dire as Illinois’.

Although the reform provides substantial cost savings to the taxpayers of Illinois, it also comes at significant costs. In this post, I want to draw three big picture lessons from this reform. I will post additional material on more detailed features of the reform in the coming days and weeks.

Sensible public pension reform in Illinois has been hamstrung by the fact that we are one of the few states whose constitution contains a clause guaranteeing that retirement benefits for public workers cannot be “diminished or impaired.” In a well-functioning system, the existence of this guarantee would have two beneficial effects. First, it would lead to better funding (“we had better fund it, because we are going to have to pay it!”) Second, it would cause workers to fully value the pension benefits being provided: thus, in a competitive labor market, wages would adjust to reflect the value of the pension, and thus the compensation package would be economically efficient.

But Illinois is far from a well-functioning political system. Thus, what the constitutional guarantee brought us was: 1) Four decades of under-funding: if benefits are guaranteed, why should workers care about funding? 2) The inability to reform the system in a logical, sensible way.

The constitutional prohibition against benefit impairment took “off the table” a whole host of sensible reforms, including my favorite: raising the retirement age to qualify for full benefits. Instead, politicians were forced to play a game of “pension Twister,” contorting policy in all sorts of ways to find a way of cutting benefits that might pass constitutional muster. Sadly, despite all of these contortions, many of us believe that the Courts are still likely to strike down this reform – on this issue, see yesterday’s post by my colleague Nolan Miller.

Lesson 2: Separating Responsibility and Control is a Bad Idea

The world is full of bad behavior that results when the entity with the power to make decisions is not the same entity that bears financial responsibility for the results. In the case of Illinois, this issue manifested itself historically through the fact that universities, community colleges, school districts and other public employers were able to make hiring decisions without any responsibility for the pension liabilities that those decisions created.

Post-reform, we will have a different manifestation of this problem. The Illinois legislature has – after a relatively brief phase-in period – absolved itself from any further financial responsibility for future public pension accruals. The funding of all “normal costs” will gradually be transferred entirely to the institutions themselves. The problem is that Illinois politicians did not also grant these same institutions the power to design and implement their own retirement plans. In short, the Illinois politicians still get to design the system – the universities and school districts just now have to pay for it. Although there are a few safeguards being put in place to guard against the most egregious abuses of this new regime, I predict it will not take long for the state to find a way to curry favor with some voting block and pass the cost onto the employers.

Lesson 3: Public Sector Accounting Rules Really Do Matter

I have blogged extensively about the many flaws of the public pension accounting standards promulgated by the Government Accounting Standards Board (for some examples, see here, here, here and here). GASB allows public pensions to discount future liabilities with an inappropriately high rate, thus understating the real scope of the problem by ignoring risk.

Unfortunately, these flawed GASB standards framed the Illinois debate, and in so doing has had the effect of 1) over-stating the extent to which the state is going to do penance for its past sins of historical under-funding, and 2) under-stating the real size of the liability being pawned off on the universities, colleges and school districts throughout the state.

The hardest hit by this provision will be those employers – such as the flagship campus of the University of Illinois at Urbana-Champaign (UIUC) – that compete in a global labor market for talent. If UIUC wishes to maintain its position as one of the leading public research universities in the nation, it will have to continue to provide a competitive compensation package: but it will now being doing so with virtually no assistance from the state. The even worse alternative would be to watch its best and brightest faculty and staff members run for the exits.

Public pension reform was badly needed in Illinois, and our elected officials ought to be congratulated for having the political will to undertake it. Unfortunately, I fear that they botched the substance of reform.

Of course, none of this may matter – I still believe there is a greater than 50% chance that the Illinois courts will overturn it.

As I’ve said before, I’m not a lawyer. But, since the Illinois House Democrats have decided to move into incentives, why not? The details of the pension reform proposal that passed an Illinois House committee today are still vague, but here is a write up about it.

Simply put: the proposals currently under consideration in which members are offered a “choice” between options, as currently constructed, are not constitutional. Here’s why.

Any contractual relationship has to have, well, a contract. In this case, the terms of the contract are spelled out in the Illinois Pension Code.

The Illinois Pension Code specifies the way in which pension benefits will be calculated. The details are slightly different for different pension funds, but I’ll talk about the part that pertains to Tier I participants in the State Universities Retirement System (SURS). In particular, the amount of the retirement annuity is specified in Section 15-136 of the Pension Code. Here it is:

Rule 1: The retirement annuity shall be … for persons who retire on or after January 1, 1998, 2.2% of the final rate of earnings for each year of service.

That seems pretty clear. The “final rate of earnings” is defined in Section 15-112. For a person who first becomes a participant before Jan. 1, 2011 (i.e., Tier I participants), the final rate of earnings is defined as:

For an employee who is paid on an hourly basis or who receives an annual salary in installments during 12 months of each academic year, the average annual earnings during the 48 consecutive calendar month period ending with the last day of final termination of employment or the 4 consecutive academic years of service in which the employee’s earnings were the highest, whichever is greater. For any other employee, the average annual earnings during the 4 consecutive academic years of service in which his or her earnings were the highest. For an employee with less than 48 months or 4 consecutive academic years of service, the average earnings during his or her entire period of service.

That also seems pretty clear.

One more excerpt from the Pension Code. This one has to do with annual cost of living adjustments (COLAs). From Section 15-136

The annuitant shall receive an increase in his or her monthly retirement annuity on each January 1 thereafter during the annuitant’s life of 3% of the monthly annuity provided under Rule 1, Rule 2, Rule 3, Rule 4, or Rule 5 contained in this Section. The change made under this subsection by P.A. 81-970 is effective January 1, 1980 and applies to each annuitant whose status as an employee terminates before or after that date.

Beginning January 1, 1990, all automatic annual increases payable under this Section shall be calculated as a percentage of the total annuity payable at the time of the increase, including all increases previously granted under this Article.

This part of the Pension Code also seems clear: COLAs are to “include all increases previously granted under this Article.” In other words, COLAs compound rather than being based on the original amount of the annuity. And, COLAs start the January after retirement.

So, let’s review. The Illinois Constitution says that membership in a pension system is a contractual relationship. The terms of that contract are given by the Pension Code, and the Pension Code specifies the way in which final pension benefits should be computed. In particular, it specifies that the final rate of earnings is average earnings over the final 4 years of service, or the 4 consecutive years in which earnings were the highest. Thus, the Pension Code states that future pay raises will be included in future pension benefits. The Pension Code also states that COLAs are to begin immediately after retirement and be computed on a compound basis.

(A) Keep the current pension plan, but give up the state subsidy for retiree health benefits and having future raises be included in pension benefits, and

(B) Keep the state subsidy for retiree health benefits, but receive a less generous cost of living adjustment (COLA) where annual increases are based on the pension payment at the time of retirement rather than the most recent year’s pension. That is, the COLA is not compounded over time. Further, the COLA will not kick in until 5 years after retirement or age 67, whichever comes first. There is also language in at least the governor’s proposal that will limit the COLA to a simple 3% or ½ the increase in the consumer price index, whichever is lower.

Now, supporters of this approach claim that is constitutional because it offers participants a choice. This claim is invalid. While a choice might be constitutional, in order for this to be the case, it must be that one of the options does not impair or diminish the benefits of the current pension system. This is not true here. Option (A) denies members their contractual right to have the final annual rate of earnings be based on their highest 4 years of earnings, which would include future raises. Option (B) denies members their contractual right to have COLAs be 3% compounded each year. Since both options impair and diminish the benefits of the pension, if members are forced to make a choice between A and B, their pension benefits will necessarily be reduced.

Constitutionally speaking, two wrongs don’t make a right.

Consequently, to me it seems clear that the proposals are not constitutional. Given that so many of our legislators are backing these proposals, there must be an argument for why the proposal is constitutional. I can’t see it, though.

ADDENDUM (5/30/12): This isn’t a post about whether it is right or fair to reduce retiree health benefits (it isn’t), but rather whether it is constitutional (it probably is). Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A. In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65. The state also does not contribute to Social Security, so state workers who retire are also not eligible for Social Security (unless it is by virtue of having worked for another employer). Obviously, removing employer-sponsored health benefits and reducing the COLA is going to expose retirees to substantial new risks, and the proposal becomes much more complicated and controversial in this case.

1) Create a new hybrid retirement system for new employees that would combine a scaled-down version of the existing SURS defined benefit plan with a new defined contribution plan that would include contributions from both employee and employer;

2) Peg the SURS “Effective Rate of Interest” to market rates;

3) Redistribute the SURS funding burden to include a modest increase in employee contributions and new direct contributions from universities, thereby reducing state government’s burden on state government; and

4) Align pension vesting rules with the private sector, which would decrease the years new employees hired after January 1, 2011 would need to work for their pension benefit to be vested.

The plan is intended to substantially reduce state expenditures on public pensions, while still providing a reasonable source of secure retirement income to university employees.

I have written on this blog before about the Government Accounting Standards Board (GASB) rules that allow public pension plans to discount their liabilities using the expected return on plan assets. This is no small technical matter … discounting in this way has the effect of dramatically understating the true economic value of the unfunded liabilities of public pension liabilities. This single accounting issue may understate the magnitude of the public pension funding problem by trillions of dollars!

GASB has issued proposed new standards and are in the process of accepting comments from the public. I submitted my comments last week, and thought I would post a few excerpts here.

“As members of the GASB Board may already know, I have been critical of existing GASB guidelines for the computation of public pension liabilities. I have a paper in the May 2009 American Economic Review (co-authored with David Wilcox of the Federal Reserve Board) in which we explain the basic economic rationale for the appropriate choice of a discount rate. Economic and financial theory is very clear that the choice of a discount rate depends on the risk of the cash flows being discounted.

This is true regardless of whether those cash flows are positive or negative, and whether they are being generated by public institutions, private institutions, or individuals. There is absolutely no economic or financial basis for discounting one set of cash flows based on the risk of a completely different set of cash flows. In other words, there is no logic whatsoever for discounting pension liabilities based on the risk of the pension plan assets.

A simple analogy illustrates this point. Suppose that at 9 a.m. on January 1, I borrow $100,000 for one year from a bank at an interest rate of 5 percent. I immediately invest the full amount in a diversified portfolio of risky assets (such as stocks and bonds) that has an “expected return” of 8 percent. By the time I have completed this transaction at 9:05 a.m. on January 1, how much do I owe the bank? Naturally, I still owe them $100,000 (ignoring the 5 minutes’ worth of interest). At this point, I have not changed by net worth at all. All I have changed is my risk exposure.

Suppose, however, that I follow GASB-like accounting rules to calculate my net worth. Because the expected return on my portfolio is 8 percent, I can use this to discount the $105,000 (principal plus 5 percent interest) that I will owe in one year (December 31). By this calculation, I would now only value the future liability as $97,222.22 (=$105,000 / 1.08), making it appear as if I have created $2,777.78 of wealth out of thin air.

Of course, if I tried to tell my lender at 9:05 a.m. on January 1 – just 5 minutes after closing the loan – that they should allow me to give them $97,222.22 and cancel my $100,000 debt, they would look at me with great puzzlement! And for good reason – I owe them $100,000 now, or $105,000 in one year, regardless of what I do with the funds in the interim! The transaction just described is absurd from the financial perspective. But as illogical as it seems, this approach closely mirrors the approach that has been taken by GASB in the past and that is still embedded in the proposed new public pension accounting guidelines.

The fundamental problem is that the use of “expected returns” as a discount rate is a largely a meaningless concept unless it is also accompanied by a discussion of, and accounting for, the accompanying risk.

The most straightforward way to do this is to discount pension liabilities based on the risk characteristics of the pension cash flows. For example, for the accumulated pension obligation (ABO) for a public pension in a state with strong constitutional guarantees against the impairment of retirement benefits, it would be appropriate to use a rate close to the risk-free rate. In other cases – such as states where pension benefits can be easily changed by the legislature and where the likelihood of change is correlated with broader economic activity – a higher discount rate should be used. In either case, what must determine the discount rate is the risk profile of the liabilities and NOT the expected return on plan assets.

In the exposure draft for the new rules, GASB seeks to replace the “expected return on plan assets” discount rate with a “blended rate.” This blended rate is a combination of the expected return on plan assets for the funded portion of the liability and a muni-bond index for the unfunded portion. Unfortunately, there is no theoretically coherent rationale for the proposed approach. Indeed, though this approach could be viewed by some as a “compromise,” the result produces an even less coherent outcome than existing policy.

There are several fatal flaws to the proposed approach, including:

1. There is no clear question to which the proposed measure is the right answer. Indeed, it is difficult to think of any outcome of interest that is meaningfully described by the output of a cash flow discounting exercise that uses the blended rate as described in the proposed rules.

2. Funded status is not a sufficient measure of the risk of pension liabilities. To be sure, it may be one such factor – at least insofar as one believes that participants in underfunded pensions are more likely to experience future benefit reductions – but it is far from a sufficient statistic. Therefore, it is an insufficient basis on which to evaluate the risk of the liabilities.

3. Even if funded status were a sufficient measure of risk (which it is not), the proposed GASB rules have blended the discount rates in the wrong proportions. If funded benefits are less risky than unfunded benefits, then the funded benefits should be discounted at a lower rate, and the unfunded ones that should be discounted at a higher rate. The proposed GASB rules turn this logic on its head, and the result is inconsistent with accepted procedures for risk adjustment.

4. Even if one wished to calculated a blended rate to account for differential risk based on funding status, the “expected return on plan assets” is not the right rate to use for the “risky” portion of benefits — unless the risk of the liabilities just so happens to correspond exactly to the risk of the asset portfolio, which is highly unlikely. For example, if liabilities are discounted using the expected return on a 60/40 equity/bond portfolio, this is equivalent to saying that the distribution of benefit payments to DB pension participants is just as risky as investing in a 60/40 portfolio. I suspect that few DB plan sponsors intend for their plans to be so risky, and fewer participants believe that their public pension is intended to be so uncertain.

5. The proposed rules provide an unattractive and dangerous incentive for plan sponsors to take on more investment risk than is optimal. If plan sponsors invest in a risker portfolio, they will then be able to “justify” a higher expected return under GASB rules. Indeed when they are permitted to use a higher expected return, they can show a larger share of their liabilities as being “funded.” This, in turn, also reduces the fraction of their liabilities that will then be discounted using the muni-bond index. In short, public pensions may be tempted to invest in a riskier asset portfolio in an attempt to shrink the reported size of their unfunded liabilities.

6. There is a good conceptual argument for using state or municipality’s bond returns as a discount rate for a public entity’s pension liabilities, at least to the extent that pension obligations and bond obligations bear comparable credit risk. However, this rate should reflect the risk of that particular state or municipality, rather than some aggregate index. More generally, different states and municipalities should use different discount rates when the risks of their pension obligations differ.

Because of these and other flaws, I believe it would be a mistake to adopt GASB’s the new proposed discounting rules. Instead, GASB should adopt standards that based discount rates on the risk of the liabilities.”

Readers of this blog know that I have written several posts over the past 2 years about the mis-use of “expected returns” as a discount rate for public pension liabilities. It turns out, this issue even has risen to the attention of Bill Sharpe, Stanford Professor and winner of the Nobel Prize in Economics for his contributions to financial economics. Don’t worry – this is not a difficult technical piece. It is a cartoon – and I highly recommend it. You can watch it by clicking here. It shows the absurdity of acting like future liabilities are smaller just because the assets are invested in a diversified portfolio. Enjoy!

The use of “default options” (i.e., an automatic decision on behalf of individuals who fail to make an active choice) has been shown to exert a strong influence on individual behavior in a variety of settings. Perhaps nowhere has this effect been more powerful than in the arena of retirement savings, where default options have been shown to dramatically increase participation in 401(k) plans and savings rates and to provide better portfolio allocations.

The widespread use of default options, however, has also been accompanied by a deeper understanding of when default options are appropriate tools for improving individuals’ well-being, and when, in contrast, default options are potentially harmful.

The State Universities Retirement System (SURS) of Illinois has, for approximately 12 years, defaulted new employees into the Traditional Defined Benefit pension plan if they fail to choose a retirement plan within six months of employment. Along with my University of Illinois College of Business colleagues Anne Farrell and Scott Weisbenner, I surveyed nearly 5,000 SURS participants who joined the system between 1999 and 2007 to better understand who defaults, why they default, and the implications of defaulting rather than actively choosing a plan.

Some key findings of the research include the following:

More than half of survey respondents who accepted the default option cite information problems or decision complexity as a primary reason for defaulting.

One in five respondents believe that because the Traditional defined-benefit plan was selected as the default option, that plan must have been the best option.

Over one-third (35.2%) of respondents who defaulted into the Traditional plan would choose a different plan if given the opportunity to do so at the time of the survey. This is more than double both the fraction of individuals who made an active choice who would like to change plans (15.5%), and the fraction of individuals who made an active choice of the Traditional plan who would like to change plans (14.0%).

Individuals who both defaulted into the Traditional plan and would like to choose a different plan if given the opportunity are substantially more likely to cite information problems.

There are numerous implications of the research, including:

Because (a) there is no single plan choice that is clearly right for all participants; (b) the choice of retirement plans is highly complex; and (c) plan choice is irrevocable, this is a context in which it is not advisable to rely heavily on a single default option.

To the extent that the Illinois legislature considers changes to the SURS system, it should consider ways to provide information that enables quality decision-making by participants. The legislature should not rely extensively on default options to convey such information.

To the extent that default options are used in the SURS system, consideration should be given to allowing default options to vary by participants’ age or income, or to allowing participants to make a one-time change to their plan enrollments.

Given that the Illinois legislature continues to debate the future of state pensions in Illinois, we think these lessons are timely.